Is a billion dollars ordinary income?

Some in Congress say private equity fortunes should be taxed as earnings (35%) rather than capital gains (15%).

WASHINGTON — In a new age of fabulous fortunes, the tax rate paid by a breed of financial billionaires is fueling a Wall Street-versus-Washington dispute over fairness in the U.S. economy.

Leaders of private equity firms such as Blackstone Group and Kohlberg Kravis Roberts & Co. are reaping huge paydays as they buy and sell some of America's biggest companies. But much of the money they pocket is considered investment income, and taxed at the 15% rate for capital gains.

Congress is now considering taxing these earnings at the ordinary income tax rate -- which for Wall Street titans (and anyone else who makes $349,700 and up) is 35%. The proposal has triggered a debate that is echoing across the political landscape and on the presidential campaign trail.

A more narrow Senate proposal would apply only to private-equity firms and other funds that are publicly traded, such as Blackstone Group.

Opponents of the legislation say the current system fosters innovation and economic growth by rewarding those who are willing to risk their money on new business ventures. Buyout firms, fund managers and the U.S. Chamber of Commerce are among those scrambling to block the tax change.

Investor Henry Kravis -- legendary for his 1989 takeover of RJR Nabisco detailed in the bestseller "Barbarians at the Gate" -- trekked to Congress recently to make his case in private meetings with lawmakers.

"A knee jerk by Congress to come in here to raise tax rates to raise revenues could have serious consequences to U.S. capital markets, to capital formation," warned R. Bruce Josten, executive vice president of the U.S. chamber.

Private equity's rise

The controversy is rooted in the rise of private equity executives from bit players to their current status as the rock stars of Wall Street. Such firms specialize in taking over troubled companies, whipping them into shape and selling them for a big profit. The biggest firms are now serious rivals to New York's blueblood investment banks.

Last month's initial public stock offering of Blackstone Group revealed just how fantastically wealthy private equity managers have become, even by Wall Street's surreal pay standards.

Stephen Schwarzman, Blackstone's chief executive, pocketed almost $400 million last year -- easily topping the $55 million earned by Lloyd Blankfein, his counterpart at Goldman Sachs Group.

After the public offering, Schwarzman's ownership stake in Blackstone was valued at about $7.5 billion, up from $3.5 billion last year.

Blackstone said in a government filing for its IPO that the measures could significantly boost the taxes owed by its executives, but said that it did not know by how much.

These days, private equity titans such as Schwarzman and Kravis are as visible in New York society as they are in corporate boardrooms, a status that recalls an earlier generation of Wall Street barons.

Schwarzman's glitzy 60th birthday bash this year featured private performances by Rod Stewart and Patti LaBelle. For his annual Christmas parties, Schwarzman, who is chairman of the Kennedy Center in Washington, has been known to decorate his Park Avenue apartment to look like a Las Vegas casino and a St. Tropez beach.

Kravis, the chief of Kohlberg Kravis Roberts & Co., has an estimated net worth of $2.6 billion. He serves on the boards of New York's Metropolitan Museum of Art and Mount Sinai Medical Center. Kravis' wife, Marie-Josee, is president of the Museum of Modern Art in New York.

As some see it, the political focus on taxes paid by the investor elite is an inevitable consequence of their huge, widely noted windfalls.

The fact that fund managers can earn millions of dollars that is taxed at 15% is "a blatant example of profiteering legally from the tax system," said Max B. Sawicky, an economist at the Economic Policy Institute.

"It offends our values as a nation when an investment manager making $50 million can pay a lower tax rate ... than a teacher making $50,000," Sen. Hillary Rodham Clinton (D-N.Y.), a presidential candidate, declared in a campaign statement.

Upside to risk-taking

For all that, critics of the tax proposals say the focus on ultra-rich private equity firms could lead to a big policy blunder.

Kate D. Mitchell, a venture capitalist from Northern California, said the proposed tax hike would hurt innovation and punish those who take risks to launch the would-be Googles of the world.